So, we know that contributions both to IRAs and 401(k)s are usually pre-tax dollars, but these plans may also be set up to take post-tax dollars, termed Roth contributions. Since Roth contributions are taxed before their deposit into the account and included in gross income, distributions at retirement are not taxed and contributions cannot be deducted on your tax return.

In the case of Roth 401(k)s, (or 403(b) plans) a separate designated Roth account is set up to receive the contributions that the employee designates as Roth contributions. Only elective contributions may be designated as Roth contributions. Employer contributions are still deposited into the employees pre-tax 401(k) account. All limitations and regulations that apply to the pre-tax 401(k) plan also apply to the Roth contributions.

IRAs – Individual Retirement Accounts or Individual Retirement Annuities
An Individual Retirement Account is an IRS approved trustee or custodial account (set up by a bank, federally insured credit union, savings and loan association, or other approved entity). An Individual Retirement Annuity is purchased from an insurance company. Both require that distributions begin by April 1st of the year following the year you turn 70 1/2. Contributions of more than the deductible amount ($5,000 for 2010 or $6,000 if you are over 50 years of age) or more than your taxable income cannot be accepted, except in the case of rollover contributions or employer contributions to a SEP-IRA. Also deductions begin to be phased out if your Adjusted Gross Income is between $89,000 and $109,000 for those Married Filing Jointly and $55,000 to $65,000 for those filing Single or Head of Household.

For more information on IRAs see Rebuilding Your Nest Egg – Parts 1 and 2.

Profit Sharing Plans
A Profit Sharing Plan is a defined contribution plan under which the plan may provide, or the employer may determine, annually, a fixed amount (for example $10,000) that will be contributed to the plan (out of profits or otherwise). Then a formula is applied to the amount to determine the portion that will be allocated to each plan participant. Contributions need not be a specific percentage of profits and they need not be made every year, as long as they are “recurring and substantial.” Profits are not required in order to make a contribution.

Up to 25% of covered payroll can be contributed and deducted by the employer. Plan contributions are normally based on total compensation; e.g., base salary, bonuses, overtime, etc. The maximum compensation recognized in 2009 and 2010 is $245,000. Since the employer already contributes to the employee’s Social Security retirement benefit, these contributions can be integrated into the allocation formula of the plan. The allocation of contributions to a participant’s account from all of the employer’s plans may not exceed the lesser of 100% of includable compensation or $49,000 per year.

In Part 5, we will look at the benefits and disadvantages of profit sharing plans both to the employer and employee and when in particular are these plans recommended.